SEP vs. 401k Updated

The SEP IRA and the Individual 401k are two of the most common retirement plans for successful self-employed individuals and owner/spouse businesses, since they offer high contribution limits and flexible annual contributions. But which is right for you—the SEP or 401k? That depends on how much you want to shelter for retirement each year.

In a nutshell: the 401k allows greater retirement contributions, but it usually involves greater administrative responsibilities and higher fees than a SEP IRA. The SEP is easier to set up and more flexible.

Features of a SEP IRA

The SEP is a great choice for self-employed people or owner/spouse businesses who want to contribute up to 25% of their W-2 earnings or 20% of net income up to the contribution limit. If that is sufficient, then the SEP will be the easier choice.

This type of plan also has the optional flexibility to allow you to convert to a Roth immediately or anytime in the future. So you can time your Roth conversion to a year, which will minimize taxes. With the Roth 401k you must pay the taxes in the year you contribute.

Also, with the SEP:

1. You must include part-time employees;
2. All employer contributions are 100% vested immediately;
3. Assets are not protected from creditors;
4. No loans are allowed.

Features of a 401k Profit Sharing Plan

A 401k PS plan offers four primary advantages over the SEP IRA:

1. Potentially greater retirement contributions at the same income level;
2. The option of a tax-free loan using the balance of the plan as collateral. Loans are permitted up to 50% of the total 401k value with a $50,000 maximum;
3. You can exclude employees who work less than 500 hours;
4. Set up a six year vesting schedule.

Contributions are flexible for either program. You can make them in some years and not in others.

The name profit sharing (PS) is actually a misnomer. It is not based on profit but on salary. In fact,
you can have a net loss on the corporation and still make PS contributions. For example, if your salary is 100K, you can put in a $25K profit sharing contribution even if your corporation shows a net profit of $1000.

For example, let’s say you decide to pay yourself 116, 000K in salary. Here’s what you can contribute to 401k Profit Sharing Plan:

Employer Profit Sharing: 25% of $116,000 = $29,000 (paid by corporation)

Salary Deferral 401k: $16,500 (for 2011 – paid by you – this is withheld from your paycheck).
Total contribution = $45,500.

This is the max you can contribute based on $116,000 of salary.

The sum of the two contributions cannot exceed your salary or $49,000 whichever is lower.

In a SEP you would only be able to contribute the $29,000.

In Conclusion…

If you value the loan feature or want to maximize your annual retirement contributions, you should consider a 401k. If not, the simplicity of a SEP IRA makes it the better choice.

Want help in determining which plan is best for you? We’d be glad to help. For more information please contact Sheree Tallerman at 917-828-5888 or sheree@planperfectretirement.com

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